What Is a Letter of Credit? Types and How It Works

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A letter of credit (LC, or L/C) is a written commitment from a bank to pay a seller a stated amount, on behalf of a buyer, once the seller presents documents that match the terms of the credit. The bank replaces the buyer’s promise to pay with its own, so the seller no longer has to trust a customer it may never have met. It has to trust the bank and produce the right paperwork on time.

Letters of credit are most closely associated with international trade, where buyer and seller often operate under different laws, currencies and courts. Domestic businesses use them too, for large purchases and as performance guarantees.

The Parties to a Letter of Credit

Each party has a defined role:

• Applicant: the buyer or importer who asks its bank to open the credit and must repay the bank.
• Beneficiary: the seller or exporter entitled to draw on the credit.
• Issuing bank: the buyer’s bank, which issues the LC and takes on the payment obligation.
• Advising bank: a bank in the seller’s country that authenticates the credit and passes it to the seller, without any obligation to pay.
• Confirming bank: a bank, often the seller’s own, that adds its own payment undertaking to the issuing bank’s.
• Nominated bank: a bank authorized to pay, accept drafts or negotiate documents on the issuing bank’s behalf.

One bank can fill more than one role. The seller’s bank is frequently both the advising bank and the confirming bank.

How a Letter of Credit Works

1. Sales contract. Buyer and seller agree on price, shipment terms and payment by letter of credit.
2. Application. The buyer applies to its bank, which checks its creditworthiness and sets the collateral or credit line required.
3. Issuance. The issuing bank opens the LC, specifying the amount, currency, expiry date, latest shipment date and the exact documents required.
4. Advice. The seller’s bank authenticates the credit and forwards it. The seller should check the terms immediately and request amendments for anything it cannot meet.
5. Shipment. The seller ships the goods and gathers the required documents.
6. Presentation. The seller submits the documents to its bank (or the nominated bank) before expiry.
7. Examination. The bank checks the documents against the credit and, if they comply, sends them to the issuing bank.
8. Payment. The issuing bank pays, or reimburses the bank that already paid, and debits the buyer or its collateral.
9. Release of goods. The buyer uses the documents, including the title document, to claim the shipment.

Documents and strict compliance

A commercial credit commonly calls for some combination of:

• Bill of lading or other transport document
• Commercial invoice
• Packing list
• Certificate of origin
• Insurance certificate
• Inspection or quality certificate

Banks apply a standard of strict compliance. A misspelled name, a late shipment date or an invoice description that does not match the credit counts as a discrepancy, and a discrepant presentation lets the issuing bank refuse payment. The buyer can waive the discrepancy, but the seller is then relying on the buyer’s goodwill again. Under UCP 600, each bank has a maximum of five banking days after the day of presentation to decide whether the documents comply.

When payment occurs

• At sight: the bank pays as soon as it confirms the documents comply.
• Usance (deferred payment or acceptance): the bank pays at a later date, such as 60 or 90 days after the bill of lading date, giving the buyer time to sell the goods first. In an acceptance credit, the bank accepts a draft that the seller can discount for earlier cash.

Either way, payment follows compliant documents, not delivery. No neutral party inspects the goods unless the credit requires an inspection certificate.

The Rules Behind Letters of Credit

Two legal principles explain why sellers value an LC. The first is independence: the credit is a separate undertaking from the sales contract, so a buyer’s quality dispute does not by itself let the bank withhold payment against compliant documents. Narrow exceptions exist, chiefly fraud. The second is that banks deal in documents: a bank examines paper, does not inspect cargo and is not responsible for whether the goods match the description.

International commercial credits are usually issued subject to UCP 600, the ICC rules in force since 2007. Under UCP 600, a credit is irrevocable even if it does not say so, which means it cannot be amended or cancelled without the agreement of the issuing bank, any confirming bank and the beneficiary. If the credit expires without a compliant presentation, the bank’s obligation ends. Standby letters of credit are often issued under ISP98 (International Standby Practices). In the United States, UCC Article 5 supplies the statutory framework. Rules adopted in the credit and local law apply together.

Types of Letters of Credit

Commercial letter of credit

The standard documentary credit described above. The issuing bank is the primary source of payment, paying the seller against the required documents, such as a bill of lading, and reducing the seller’s non-payment risk in ordinary trade.

Standby letter of credit

A standby letter of credit (SBLC) is a secondary payment mechanism: the bank pays only if the applicant fails to do something it promised, such as paying an invoice or completing a project. A commercial LC is drawn when the deal goes as planned, while a standby is drawn when it does not, so it works more like insurance. Standbys back construction performance, lease obligations, supplier credit terms and similar commitments, and a draw usually requires a demand and a statement of default rather than shipping documents.

Revolving letter of credit

A revolving LC allows multiple draws over a set period, often around one year, up to a per-draw or total limit, without a new credit for each shipment. It suits ongoing supply relationships with regular deliveries. It may be cumulative (unused amounts carry forward) or non-cumulative (they lapse).

Confirmed letter of credit

In a confirmed LC, a second bank, usually in the seller’s country, adds its own undertaking to pay. This protects the seller if the issuing bank or its country cannot or will not pay, for example because of sanctions, currency controls or the bank’s own weakness. Confirmation costs more, and the fee depends on how the confirming bank views the issuing bank’s credit strength and country risk.

Transferable letter of credit

A transferable LC lets the original beneficiary assign all or part of the right to draw to another party, such as a corporate parent or the actual supplier. Intermediaries and trading companies use it to pay their own suppliers from the buyer’s credit. A credit is transferable only if it explicitly says so.

Red clause letter of credit

A red clause credit gives the seller an advance before shipment, often to buy raw materials or cover production. The issuing bank, and ultimately the buyer, carries the risk that the seller takes the advance and does not ship. The clause was historically printed in red ink.

Traveler’s letter of credit

A largely historical instrument guaranteeing that a traveler’s drafts at specified foreign correspondent banks would be honored. Cards and electronic payments have mostly replaced it.

How Much Does a Letter of Credit Cost?

Banks price letters of credit by type, size, tenor and risk. Charges can include:

• Issuance or opening fee, commonly a percentage of the credit amount and often charged per period the credit is outstanding
• Advising fee
• Confirmation fee, for confirmed credits
• Amendment fees
• Discrepancy fees, charged when documents do not comply
• Negotiation, payment or acceptance fees
• Courier and SWIFT messaging charges

Who pays which charge is negotiable and written into the credit. Buyers usually bear the issuance cost, while the seller often pays charges in its own country.

Hypothetical example: a 0.75% issuance fee on a $400,000 credit is $400,000 × 0.0075 = $3,000, assuming a single flat charge for the credit’s term. A confirmation fee, amendments or a discrepancy would add to it.

Collateral is a separate cost: a bank may ask for cash margin, securities, or a reduction in the buyer’s available credit line. The bank pays the seller and then looks to the buyer for reimbursement, so the LC uses the buyer’s borrowing capacity even before any money moves.

Example of a Letter of Credit

Hypothetical example: a US furniture retailer agrees to buy $250,000 of tables from a manufacturer in Vietnam that has never worked with it and will not ship on open account. The retailer will not pay in advance.

The retailer’s bank issues an irrevocable LC for $250,000, payable 60 days after the bill of lading date. It requires a clean on-board bill of lading, a commercial invoice, a packing list and a certificate of origin, with a latest shipment date of June 30 and expiry on July 21. Because the manufacturer is unsure about the issuing bank, its own bank in Vietnam confirms the credit.

The manufacturer ships on June 25 and presents the documents on July 2. The confirming bank finds them compliant and forwards them, and the issuing bank pays at maturity, 60 days after June 25. The retailer uses the bill of lading to collect the tables, and its bank debits the retailer’s account or credit line.

Change one detail: if the invoice had described the goods as “oak tables” while the credit said “walnut tables,” the presentation would be discrepant, and payment would depend on the retailer agreeing to waive the discrepancy.

Benefits and Limitations

Benefits

• The seller’s payment risk shifts from the buyer to a bank, or to two banks if the credit is confirmed.
• The buyer avoids paying in advance and pays only against specified documents, including proof of shipment.
• Shipment dates, documents and payment timing are set out precisely and can be tailored to each deal, and usance credits give the buyer time to pay.

Limitations

• Fees and collateral make LCs more expensive than open account or documentary collection, and buyers usually carry much of that cost.
• Document preparation and checking take time, and small errors can delay or block payment.
• The buyer is protected only by the documents it specifies, and document fraud is possible.
• Fixed terms may not adapt well to political or economic shocks.

Letter of Credit vs. Related Instruments

Bank guarantee: both are bank undertakings, but a commercial LC is the expected means of payment, while a guarantee, like a standby LC, pays only on default. Standbys and demand guarantees work very similarly, and the choice often depends on local practice and law.

Documentary collection: banks release the documents against payment or acceptance, but collecting banks make no promise to pay. If the buyer refuses, the seller is left with goods at a foreign port.

Line of credit: a line of credit lends money to the borrower. A letter of credit is a promise to pay a third party. Banks often issue LCs under a credit facility, which is why an open LC reduces the borrowing available to the buyer.

Escrow: escrow holds deposited funds until conditions are met. An LC generally does not require the buyer to deposit the full amount up front (unless the bank demands 100% cash margin), and the release condition is documentary rather than a neutral confirmation of delivery.

The Bottom Line

Exporters and importers dealing with unfamiliar counterparties gain the most from a letter of credit, since it lets a seller rely on a bank and a buyer avoid paying in advance. The protection depends entirely on paperwork, so both sides should check terms early and prepare documents precisely. Buyers should also budget for fees and collateral, which can make an LC costlier than open account or documentary collection.